Who gains most from 401(k) tax breaks?

In the discussion over retirement security, retirement plans like 401(k)s are often talked about as if they benefit all Americans equally. But with these tax-deferred accounts coming under scrutiny amid the fiscal-cliff budget debate, it’s worth remembering: They’re a perk that’s far more valuable to the upper-middle-income, corporate golf-outing set than to store clerks or assembly-line workers.

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The rules governing 401(k)s, of course, allow investors to put off paying income tax on wages they sock away for retirement. That money gets taxed eventually – when they withdraw it. With the fiscal cliff looming, Congress has been searching high and low for tax breaks to cut. While monkeying with 401(k)s is probably still a long shot, proposals to trim or eliminate the break on 401(k) contributions have been floated by the bipartisan Simpson-Bowles deficit commission and the Brookings Institution, a think tank.

The accounts came under closer scrutiny last week after an academic study suggested their tax breaks may be ineffective in prompting people to save for retirement. Meanwhile a business group has launched what it calls a “grass-roots campaign” to fend off criticism.

(For a defense of the tax break by one of MarketWatch’s “RetireMentor” columnists, Jim Phillips, read here.)

For high earners, the benefits of the 401(k) system go well beyond the initial break. Those earners often end up paying lower income tax rates in retirement than they did during their working lives. And, far more importantly, the accounts also allow investors to avoid paying pay taxes on investment income like interest and dividends as their balances accumulate.

The problem: tax breaks that promote retirement saving cost the government dearly – about $200 billion a year, according to a 2009 study by the Tax Policy Center, a joint project between the Brookings Institution and the Urban Institute, another think tank.

What would be the effect of eliminating the breaks? The Tax Policy Center found the biggest hit would to those making roughly $160,000 to $600,000, whose after-tax incomes would decline about 4%. Those making up to roughly $66,000 would see incomes fall by less than 1%.

Why? One big reason is that the working class pays lower tax rates, so dollar-for-dollar any deduction is likely to be less valuable to them. They’re also less likely to have the kind of jobs that offer a 401(k) plan and, when they do, less likely to be able to spare money to sock away.

“Lower income people aren’t saving very much,” says Eric Toder, a co-author of the Tax Policy Center study.

One other group that wouldn’t miss the 401(k) much: the super rich. The top 1% who make more than $600,000 a year would see incomes drop only about 2%, because 401(k) individual contributions are capped – at $17,000 for 2012 and $22,500 for those over 50. Although these big shots can usually afford to max out their plans, a change in tax status would have a less dramatic effect on their well-being, because tax-deferred accounts makeup relatively little of their overall savings and income.

There is one big caveat, which defenders of the tax break emphasize and the Tax Policy Center acknowledges is significant. Economic studies typically assume that cutting a fringe benefit like a 401(k) would result in an offsetting bump in wages, keeping employees’ total compensation essentially level.

For lower-income workers that might not be entirely true. Federal non-discrimination rules forbid employers from designing plans solely to benefit the best-paid workers, and research suggests that to comply with the law, some companies end up sweetening the pot for the rank-and-file, so they can offer attractive perks to the top brass. As a result, eliminating or limiting the 401(k) tax break could prompt these companies to cut plans without offering lower-paid workers any other compensation to make up the difference.

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